Debtor’s Fraudulent Transfer of Property Set Aside Years After Trust Was Formed

In a recent bankruptcy case, the Ninth Circuit held that a transfer to a trust could be set aside years after the transfer was made.  In In re Schwarzkopf (9th Cir Nov. 23, 2010) ___ F.3d ___, the court held that, because the transfer was a fraud on creditors at the time it was made, the taint of fraud was not erased by the passage of time.

Accordingly, when the debtors filed a bankruptcy petition more than a decade after the trust was formed, the trustee could set aside the transfer and recover the property for benefit of other creditors.

This result is somewhat surprising, considering that California law provides a seven-year statute of limitations to challenge a fraudulent transfer.  The court held that the statute of limitations did not start to run until years later, when the named trustee disputed that the trust assets were part of the bankruptcy estate.

The underlying facts were as follows.  “The Debtors created both the Apartment Trust and the Grove Trust on June 15, 1992. They named their minor child, Sydnee Michaels [as] beneficiary and appointed Juan Briones [as] trustee.  Simultaneously with the creation of the Apartment Trust, Michaels transferred all the stock of Kokee Woods Apartments, Inc. to the Apartment Trust.”

The trial court found that the 1992 conveyance was fraudulent.  Specifically, “the bankruptcy court found that . . . the Debtors were insolvent and that [the Debtors] devised the transfer to avoid his creditors’ ability to recover the asset.  Therefore, it concluded, the transfer was made for the fraudulent purpose of avoiding the Debtors’ creditors.”

Now, as it turned out, the debtors subsequently became solvent – “After the transfer, Michaels successfully appealed the verdict.”  But that did not cure the taint that existed at the time of the original transfer to trust.

This action was commenced in bankruptcy court.  “In October 2003, the Debtors filed bankruptcy petitions seeking to discharge approximately $5.4 million in debt.  Goodrich, as trustee for the consolidated bankruptcy estates, filed an adversary complaint seeking to recover approximately $4 million in assets from the Apartment Trust and the Grove Trust.“

Held the Ninth Circuit, “We agree with the district court’s conclusion that the Apartment Trust is invalid, and we further hold that Goodrich’s claim to invalidate it is not time-barred.  Because we hold that the Apartment Trust is invalid and may therefore be disregarded, we need not address whether it is Michaels’s alter ego.”

General Grant Tree

Explained the court, “It is well-settled that a trust created for the purpose of defrauding creditors or other persons is illegal and may be disregarded.  Properly designating a minor child as a beneficiary does not validate a trust that was created with an improper purpose.”

“Here, the bankruptcy court found that Michaels transferred the Kokee Woods stock simultaneously with the creation of the Apartment Trust and that the transfer ‘was made for the fraudulent purpose of avoiding the Debtors’ creditors.’  Those findings are sufficient to establish that Michaels’s purpose in creating the trust was to defraud creditors.  The Apartment Trust is therefore an invalid trust.”

As an invalid trust, the passage of time did not wash away any sins at the inception of the trust.  “Even to the extent it alleges fraudulent transfer, Goodrich’s claim is not time-barred by the seven-year statute of limitations set forth in California Civil Code § 3439.09(c).  If an express trust fails – if, for instance, it was formed for a fraudulent purpose – the trustee holds legal title to the property on a resulting trust for the trustor and his or her heirs.“

What the court is saying, implicitly, is that a fraudulent conveyance in trust is an illegal transfer, and will never become valid, notwithstanding the passage of time.

“Because the Apartment Trust is invalid, Briones is a voluntary trustee on a resulting trust for Michaels and his heirs. The statute of limitations did not begin to run until Briones repudiated the trust, that is, until he answered Goodrich’s complaint and denied that the Apartment Trust’s assets are property of the bankruptcy estate. We therefore conclude that Goodrich’s claim is not time-barred, and we affirm the district court’s judgment that the Apartment Trust is invalid.”

In re Schwarzkopf (9th Cir Nov. 23, 2010) ___ F.3d ___